Writing about random topics

The bailout and how we got into this mess – part 1

Today, the Senate passed a bill totaling $817 billion. That’s nearly a trillion dollars. "Holy flirking schnit!" I said to myself when I saw the size of it. Combined with the $800 billion TARP bailout earlier this year plus the original $200 billion stimulus plus all the other bailouts of individual companies, we’re approaching nearly $2 trillion.

So how did we get into this mess? Is the government buying up all these assets, cutting taxes and embarking on new spending projects really a good thing? Let’s examine these things one by one, starting at the beginning. I’ll put everything into an oversimplified nutshell.

It all started during the Clinton era when the government passed a law called the Community Reinvestment Act. This law, continued during the Bush Administration, was designed to increase housing among all Americans but especially among minorities. Government encouraged pseudo-federal organizations like Fannie Mae and Freddie Mac to become less stringent in their lending standards. In 2001-2002, the Federal Reserve cut interest rates to 1% and long term mortgage rates dropped alongside them. This was a perfect storm.

People with No-Income-No-Job got loans (NINJA loans). Everyone could get loans and banks were happy to lend the money. Loans were cheap because interest rates were low; it was assumed that people could refinance before the floating rates went up.

To further complicate matters, as interest rates declined in recent years, investors — particularly conservative ones — sought to increase their return without giving up safety and liquidity. They wanted something for nothing, and the market obliged. They were given instruments ultimately based on mortgages on private homes. They therefore had a very real asset base — a house — and therefore had collateral. The value of homes historically had risen, and therefore the value of the assets appeared secured. Financial instruments of increasing complexity eventually were devised, which were bought by conservative investors. In due course, these instruments were bought by less conservative investors, who used them as collateral for borrowing money. They used this money to buy other instruments in a pyramiding scheme that rested on one premise: the existence of houses whose value remained stable or grew.

So we have the following:

Government that encouraged home purchasing

A Federal Reserve lowering interest rates

Banks lending out money to people who were risky

Investors willing to purchase the securities

So long as house prices kept going up, things held together. But eventually, interest rates began to rise. The assumption that homeowners would do anything in their power to keep their home is a valid one, but it stopped working. When your mortgage payment goes up 50%-100%, you have less incentive to keep making it. Homeowners could no longer afford their mortgages, so they stopped paying and started walking away. Suddenly, the bank was stuck with an asset and nobody was paying for it.

Banks have always had to foreclose on homes, but now they had to foreclose on a lot more. Demand dried up because rates were too high; banks suddenly had a lot of houses on their hands with nobody paying back the loans on the money they lent out.

Banks are in the process of lending money, it’s what keeps their business going. At a certain point, the facts could no longer be hidden, and vast amounts of value evaporated — taking with them not only the vast pyramids of those who first created the instruments and then borrowed heavily against them, but also the more conservative investors trying to put their money in a secure space while squeezing out a few extra points of interest. The decline in housing prices triggered massive losses of money in the financial markets, as well as reluctance to lend based on uncertainty of values. The result was a liquidity crisis, which simply meant that a lot of people had gone broke and that those who still had money weren’t lending it — certainly not to financial institutions. Money started to "freeze." It became very difficult to borrow money because nobody was sure if the guy they were lending it to had a lot of bad assets on their balance sheets and would later on default on the loan.

So that, in a nutshell, is how we got here. But there is more, much more to the story. And that is something I will go into during my next few posts.